The draconian hidden penalty on student loans

FORTUNE — Republicans and Democrats in Congress continue to debate whether to hold down interest rates on federal student loans. The rates on the most common type, “Stafford loans,” have been low since 2007– 3.4% for this academic year. But they are scheduled to double on July 1 if Congress doesn’t act. Senate Republicans on Tuesday blocked a Democratic bill to extend the rate. However, there’s another mostly hidden, rarely publicized percentage rate coming out of the U.S. Department of Education (DOE) that ought to be getting attention: If you default on your student loan, you’re subject to a penalty up to 25% of the amount in default.

Remarkably, according to a DOE spokesperson, one in six students in default are assessed the 25% penalty after collection efforts of more than 14 months. In practice, given DOE leniency, most borrowers won’t ever have to pay the 25% penalty. But some will and, in theory, most might have to pay at least some part of the penalty.

It’s the kind of draconian penalty that would have critics up in arms if it was being imposed by a private lender with the government’s dominant market share. The penalty is based not on the actual cost of collecting a particular defaulted borrower’s loans, but on an average of all collections. So, for example, if a student voluntarily and immediately rehabilitates his loans at minimal cost to the government, he may still wind up subsidizing the collection of other debt. That’s “unfair,” says Mark Kantrowitz, an expert on student financial aid and the founder of FinAid.org, a financial aid resource website. “Responsibility should go both ways.” Moreover, he says, given “the government’s strong powers to compel repayment, why are the collection costs so high — does 25% sound reasonable to you?”

The DOE says many borrowers in default pay reduced penalties because they rehabilitate or consolidate their loans. Those who did pay a penalty in fiscal 2011 paid an average of 6.7%; in fiscal 2011, DOE collected from 800,000 students in default.

Perhaps the most significant problem with the 25% penalty is that it isn’t particularly well-disclosed. Though borrowers receive ample warning about the general perils of default — getting sued, getting wages garnished, getting income-tax refunds intercepted, paying collection fees, having your credit rating pummeled — there apparently is only one Web page at the Department of Education that mentions the 25% penalty. “The amount needed to satisfy a student loan debt collected” by the DOE’s third-party collection agents “will be up to 25% more than the principal and interest repaid by the borrower,” states a Federal Student Aid page that’s one of six tabs available on the FSA’s introductory default page.

Justin Hamilton, a DOE spokesperson, said the government’s disclosure of the penalty was adequate. He said “the 25% fee is a cap in place to protect students, because over the long run it costs us more to collect than to get the student back into an affordable repayment plan.” By contrast, Hamilton said, private lenders “compensate their collectors based on dollars recovered and there is no upper limit. So our listed 25% fee is more transparent.” Despite requests from Fortune, the DOE offered no examples of private collectors charging more than a 25% penalty to collect. A review of the price lists of collection agents used by the government — publicly provided by the General Services Administration — suggests that the 25% rate is roughly comparable to what private lenders charge.

Of the many thousands who have been assessed the 25%, Hamilton said “a majority” have the penalty waived when they get back on the payment track. Some borrowers with public-service jobs or teaching in low-income schools may have their loans forgiven altogether; borrowers who are ill or have certain financial hardships may get to postpone their payments. For those who do end up having to pay the penalty, the DOE amortizes it over a decade and the money comes from wage garnishment.

The federal government has a student-loan portfolio of roughly $800 billion, some of it dating to the 1960s. (The $800 billion represents about four-fifths of the overall $1 trillion in student-loan debt that includes private lenders.) There are 36 million students with outstanding debt on federal loans; about 16% of those students — 5.7 million — are in default. For students in default, the average amount is $8,000, though some — like those who went to medical school — might have $100,000 in default. (One of the ironies of the data is that defaulting students tend to have relatively low amounts in default because those students tend not to have completed their degrees and thereby have less earning power to pay back their loans; those borrowers in default who get bachelor’s degrees have about an average $25,000 in default but, ultimately, they are more likely to wind up paying.)

The FSA handles the student-loan portfolio, making it in effect one of the largest banks in the country. And the feds are now the primary lenders to students; of new loans being granted, 93% is federal. Of the overall $800 billion, about 6% — $50 billion — is in default. And the numbers are getting worse. Of late, presumably because of hard economic times, about 12% of loans go into default. In 2011, that was more than $9 billion, which represents several hundred-thousand students. Clearly, there’s a lot of money on the line. The government ought to make it clear to students at the outset the penalties they may face for not ponying up.